Explaining the Criteria of the Graham Formula When Finding Underpriced Stocks

Benjamin Graham is known as the “father of value investing” due to his extensive work in the field and his overall contribution to investing. When it comes to underpriced stocks & the graham formula, 1949’s The Intelligent Investor is the go-to bible for many value investors.

The Graham formula, therefore, set a precedent in how to approach valuing stocks. With a number of methods designed to identify value stocks which would potentially gain considerable price appreciation, Graham devised a simple approach which is still used by many investors to this day.

The Graham Formula & Underpriced Stocks

Context is everything when valuing stocks, and Graham was a cerebral investor. While many may argue that his initial motivation was driven by the cheap price of stocks, but eventually he had amassed enough experience to devise his famous formula.

Graham touched on this in The Intelligent Investor:

“Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the valuation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations”.

Graham devised steps to adhere to, which would determine the best approach in identifying undervalued stocks.

Undervalued Stocks & Graham’s Criteria

Criteria 1: Investors should seek stocks with a quality rating of average or better. Graham recommended Standard & Poor’s (S&P’s) rating system to do this, picking those stocks with an S&P Earnings & Dividend Rating with a minimum of a B. The S&P rating ranges from A+ down to D, which will give you an idea of where a B rating sits.

Criteria 2: Graham recommended buying stocks in companies with Total Debt to Current Asset ratios which were less than 1.10. Investing in companies with a low debt load should be a prerequisite for any savvy investor, especially when the economy is weak. Total Debt to Current Asset ratios are available in data supplied by Standard & Poors and other institutions.

Criteria 3: The third step is to check the Current Ratio – which is the current assets divided by current liabilities – in order to identify companies with a ratio of 1.50 and above. An investor must ensure that a company has sufficient assets to get through tough times, after all.

Criteria 4: Finding companies who have positive earnings per share growth in the past five years – and with no earnings deficits – is the fourth step on Graham’s criteria. Earnings must be higher in the fifth year (or the most recent year) than in the previous years.

By rejecting companies with earnings deficits in the past five years, you will ensure that you avoid considerable risk.

Criteria 5: Simply put, investors should be looking to invest in companies with price to earnings per share (P/E) ratios of 9.0 or below. As the point behind this is to identify companies selling at unvalued prices, eliminating high-growth companies is attained by only opting for companies with low P/E values.

Criteria 6: Graham recommended finding companies with price to book value ratios (P/BV) under 1.20. P/BV ratios can be found by dividing the current price by the most recent book value per share of a company. As such, stocks which sell near or below their book value is beneficial.

Criteria 7: By investing in companies which currently pay dividends, you will collect while you wait for your undervalued stock to attain an overvalued status. As investing in underpriced companies will take time, this is always an exceptionally shrewd move.

In Conclusion

The factors and context which come into play when identifying undervalued stocks cannot be ignored. There is a myriad of problems which a company can encounter which contribute to their price. If there is ample reason to believe that there can be profit attained from a company, any investor must take these factors into consideration. Can that stock genuinely improve performance, or will it continue a downward trajectory which will see your investment fail?